PAKISTAN HAS been embroiled in addressing the pressing issue of which financial system to follow. This has, to date, been dealt with by substituting English terms with Arabic terms without bothering to understand the aspects related to risk, return, investment objective and legal repercussions (also referred to as investment framework) of implementing such a system.

It’s interesting to see that people feel a sense of comfort (from the perspective of religious compliance) by using the term ‘Ijara’ instead of leasing and Mudarabah or Musharaka instead of partnership. Proponents of an Islamic financial system seem to go for the form rather than substance.

If we investigate civilization as existed in the 7th century, we would find that money (as we know it today) did not exist. Today, we carry our wealth conveniently in our wallets without having to worry about its perishability, divisibility, acceptability or transportability. But, we are constantly fearful about its use as a store of value.

In the 7th century, people would hold wealth in its primitive form; land, jewellry, domesticated animals, and agricultural produce. They would pay taxes in the same form. Gold coins or coins made of precious metals were generally used to effect inter- or intra-governmental transfers, to commemorate events of importance or to bestow medallions for achievement. Historians have been unable to uncover any evidence to support that such money was in circulation among the masses.

The present economic system would, at best, be described a barter-based system, with traders taking one set of goods and exchanging it with another set of goods. Wages, predominantly, were being paid in kind. When loans were advanced, they were denominated in the goods lent. The return of that was set in terms of an increase expected against the goods lent. To give an example, if one kilogram of wheat was lent for a specific period, the borrower would return the kilogram of wheat at the end of the period.

Fiat currency, or currency of trust, has no intrinsic value. This means that the value of money is determined on the solitary basis of supply of money as compared to the acceptability of it with those with goods and services. On the other hand, in mediaeval times money (in case if gold coins were taken as representing money) would be used for purposes other than just money and could be used for adorning (jewellry) or for medical purposes (dental).

The government primarily maintains the integrity of the currency by ensuring that the supply of the currency is in appropriate proportion to the level of goods and services in the economy and at the same time is considered a good store of value.

On an international basis, Turkey is a state of Muslims that had an inflation rate of 100 per cent in the 1990s and interest rates that matched the level of inflation. On the other hand, we have Japan that has a deflation of about two per cent and the interest on short-term government securities of nearly 0 per cent. Having said that, the real return on Japanese government securities would be higher than those available on Turkish government securities.

It is a fallacy to determine the level of return on the basis of CPI. CPI only represents the level of inflation on the basket of goods and services “consumed” by the citizens of the country. However, the money that goes into investment is generally not competing with the levels of inflation represented by the changes in the CPI. On the other hand, investment funds, generally benchmark to capital (real) goods. This is why when the Pakistani rupee or Turkish lira has been unable to maintain its integrity in terms of store of value, we find that investors prefer to hold real estate or currencies with stable store of value (i.e. dollar, euro, yen).

Another important issue is that, just like it is acceptable by people advocating Islamic finances that buying and selling goods is acceptable, it should be equally acceptable that people buy and sell future levels of inflation. Since money represents value in terms of real assets, and it is accepted that inflation erodes purchasing power of money against real assets, the owner of money should have the right to negotiate to restrict the value in nominal terms that he would accept back.

This means that if the inflation is at a higher level (and this is generally the case with bank deposits) than the interest rate then the depositor should be free to enter into this transaction. At the same time, if the borrower expects that inflation would be higher than the rate at which money is being lent to him he would enter into the transaction to borrow. As mentioned above, it should be clear that inflation by these two individuals (depositor and borrower) may not have the same benchmark or a universal benchmark (like CPI, gold, etc.) and may be totally unique to that person (ea. airline tickets, real estate value in a particular locality, etc.).

Interest versus usury: The question is, what should be the return that would qualify as being non-usurious in an economy? The answer to this question would lie in the answer of what the risks are. When the Quran talked about prohibiting people from requiring a return of 2 or 3 times the original debt, it was obviously referring to the time period that it was revealed in. This as it has already been explained above, was at the time of the barter system and of real wealth (as opposed to financial wealth).

Today, when inflation may be 500 per cent p.a. (as was in certain Latin American countries in the 1970s), the prices of real goods would increase 4 per cent every 3 days. So any definition of usury should clearly be adjusted for inflation.

The second facet of risk would be credit risk. It is obvious that the price of the risk can never be 100 per cent. This is because, in the event the risk of default is 100 per cent, the lender would not lend to the borrower. So,the credit or default risk has to be less than 100 per cent. Mach lender has its own default risk model and such models are also prevalent in the credit rating agencies. In fact, rating agencies like S&P and Moody’s publish the performances (in terms of defaults for each credit grade) of their rated companies. In addition, they also publish the probability of companies being downgraded to other credit grades.

Just like insurance companies that set up their premiums on the basis of analysis of insurance claims, competing for business that offers them the best price for the level of risk, so do banks offer credit facilities to companies that are willing to pay the best possible interest rate for the given level of default risk. This is not to say that those rates would necessarily be usurious in a free market. If there are a significant number of market participants, any super normal profits would be whittled away till the revenues reflect the risk embedded in the transaction.

It is, therefore,important for the government to ensure that there is a healthy level of competition in the market place. This would lead to the objective of eliminating usurious interest rates. The entrepreneur, on the other hand, ensures that the business risks undertaken (production, marketing / competition, and general economic risks - growth and inflation) are acceptable. Obviously, while the business is paying for inflation risk to the lender, it is,at the same time, anticipating that its net revenues would go up at a rate that would be better than the inflation price paid for borrowing.

Risk return trade-off: Finally, the investors are not a homogeneous body of individuals with similar level of risk appetite or objectives. Capital providers may hold funds for a day or may have an investment horizon of 30 years or more. Now, it is important to maintain the perspective that any system devised,should be equally applicable in a hyperinflation any economy or a deflation economy. if the capital provider was to hold his funds in a financial asset for three days in a hyperinflationary economy (say 500 per cent p a.), he would expect at least a 4 per cent return for that period. He has no interest in the economic return of the entrepreneur that has been as a result of the franchise value generated by the business or because of improvement in general economic conditions or the fact that the business has been able to develop a new product or process.

Since the objective is not to participate in the overall business value but to protect the purchasing power, the capital provider would be happy with a limited return for holding the financial asset. In the case of the Islamic Financial Model being propagated that talks about eliminating these avenues, the person with the surplus wealth would have no alternative then to hold real assets (as was being done 1400 years back) not for the purposes of hoarding but maintaining a constant level of wealth. However, this would have a devastating effect on the economy. Individuals and businesses,instead of producing goods to satisfy consumer needs would be producing goods so that they may be held as a store of value. The integrity of the currency would be diminished and the work of the government to promote better quality of life will be hindered.

On the other hand, the provider of capital who is interested in taking economic risks of investing in a business would require a return that would not only compensate him for the inflation risk assumed but also the default risk. In addition, since there would be no first protection against the operating loss being a shareholder would require a return that would be higher than the inflation risk and default risk.

This means that those individuals who publicize that the Islamic financial system will reduce the cost of financing as part of the product cost (and hence inflation) need to think again. Just because the company is under no contractual obligation to pay a return, the capital providers would not provide them the funds if the return objectives were not met.

It is interesting to note that those proponents of the Islamic financial system readily defend charging different rates of mark up as compared to current prices for the same period, if currencies are different. This means while they might buy cotton and sell the same to me for a six month deferred payment at 20 per cent plus in Pakistani rupees, they would not do so if the contractual currency were Turkish lira.

While obviously there are lenders that lend at usurious rates, this is no excuse to throw the baby out with the bath waters by eliminating a system for equitable distribution of resources on the basis of marginal efficiency of capital. In fact, the government needs to ensure that the financial system is flexible, transparent and competitive. In this way, a fair and efficient financial system would evolve as envisioned by the Quran.